Implicit Costs Maim Investors

When evaluating investment cost, most focus on the obvious rather than the obscure. However, educated investors understand evaluating costs requires more than simply looking at stated (explicit) fees. Today I’m focusing on unstated (implicit) costs that do not show up on a fund screening site or in a prospectus.

Long term investors attempt to structure a diversified portfolio of stocks and bonds. This is most commonly achieved by owning mutual funds. The “expense ratio” (annual fee) of these funds can be found within a prospectus or on most fund screening sites. But the expense ratio itself doesn’t tell the entire story when it comes to total expenses created within these investments.

Funds incur other costs passed to investors when the manager buys and sells underlying securities on behalf of the fund owners. The average fund manager turns over the entire portfolio each year , despite that this flies in the face of a known successful strategy— buy and hold. Every one of these trades incurs additional charges to the fund holder. In cases like this, the implicit costs may be even higher than known fees. When added together, it is not uncommon for fund costs to exceed 3% per year.

Expenses in investing are similar to walking in a swimming pool. The higher the cost incurred, the deeper the pool, and the slower the headway. One of the biggest favors any investor can do him/herself is to stay in the shallow end of the pool.

At Wiser, we actually try to stay in the baby pool. Sure, there is no diving, but how much did you enjoy the last time your portfolio went for a dive?

Prudence dictates minimizing the things that we know are likely to detract from future value. Academically it is long proven that the number one detracting element in investing is cost. That said, looking for ways to avoid all costs isn’t a realistic expectation either.

The point is to be aware of the trade off between cost and value. Funds that trade a lot do so in an effort to add value by achieving higher returns than the market. But these managers, primarily due to the excess costs involved, rarely attain this end. In a way it is like the manager is trying to lift the bucket he is standing in.

The compound affect of this drag is substantial. A recent Government Accountability Office study estimated that 1% in unnecessary cost on a portfolio averaging 8% return can be devastating.

According to this study if you incurred implicit costs of 1% and started with $100,000 you would end with $387,000 twenty years later. Without the added cost the value would be $466,000. Over 30 years— $761,000 vs. $1,000,000. Ouch.

The good news is, once understood, implicit costs can be managed. Minimizing the internal costs of your portfolio by holding low-turnover investments is an important part of being a prudent life-long investor.

We would like to congratulate David R. for correctly answering last week’s trivia question. He even showed the math, impressive.

I appreciate and welcome feedback or comments…warmly,

Marc Becker